This is a common question for many people who have just visited with a financial advisor who recommended a variable universal life insurance policy. The answer, unfortunately, is not as straightforward as you may hope, and the real answer is “it depends”. The simple answer is that in most cases, a traditional whole life insurance policy is a better choice than a variable universal life insurance contract.
A traditional whole life insurance contract has scheduled premiums that do not change, the dividend growth is relatively predictable and has minimum guarantees, and as long as the premiums are paid as scheduled, the policy will not lapse. This is a very safe form of life insurance that will cover the insured person no matter how long they live or what happens in the marketplace. The cost of insurance never rises, and dividend payments are often higher than illustrated, and the growth in cash value is slow and steady. The advantages of a whole life insurance policy are clear, it is an affordable form of permanent life insurance which also may generate income from dividend payments.
Advantage of A Variable Universal Life Insurance Policy
In theory, a variable universal life insurance policy sounds like it has many advantages over a traditional whole life insurance contract. For those who are unfamiliar with how they work, please read our detailed description here. Briefly, a variable universal life insurance policy acts like a permanent renewable term life policy, with a cash value. A policy holder will pay insurance premiums into the cash value. The cash value is invested in “sub accounts” which are basically mutual funds within the policy. The owner of the policy has complete discretion over which accounts the money will be invested in. From this cash value, each month the insurance charges are pulled. The idea is that a policy owner will pay more into the policy than what is necessary to cover the cost of insurance in the early years. This will build up a large cash value over time, which will become larger with they hypothetical growth in the market. At some point, the cash value plus the expected market growth will be large enough that the owner does not need to make payments any longer. Hypothetically, because the stock market has historically returned about 12% per year, the expected growth in cash value is much higher than the expected growth from dividend payments in a whole life insurance policy.
People with a lot of money can use a variable universal life insurance policy as an investment account, which they can pass onto the next generation free of tax. For these people a VUL policy can be a great estate planning tool.
Problems With Variable Universal Life Insurance
Unfortunately, there are a number of issues with this rosy picture. The biggest issue that owners of variable life insurance policies encounter is that a variable universal life insurance policy is not guaranteed to stay in force for the full lifetime of the policy owner, even if they have been making their scheduled premium payments all along. A policy will still lapse if there is insufficient cash value to cover the monthly insurance charge deductions. There are a couple of reasons this occurs even with an owner making what they think are sufficient payments.
The first is that the actual cost of insurance, also known as the insurance charge deduction, rises every year over the lifetime of the policy. When policy holders are very old and need the insurance the most, their insurance charges can become extremely high. If the cash value is depleted it becomes extremely difficult for most people to cover the high insurance costs out of pocket if there is not enough cash value invested in the policy in the sub accounts. The way insurance charges are calculated with variable policies is a little complicated and depends upon a number of factors. Charges are quoted in “cost per thousand at risk”. The charge per dollar at risk to the insurance company (this is defined as the death benefit that would be paid on a claim, minus the current cash value) unequivocally will rise over time. Lower cash values typically mean higher insurance charges for the policy because the amount at risk is higher. When you combine a high amount at risk with no value to draw from the cash value for insurance costs, the cost of the policy easily become unmanageable for many people. The important point is that if the policy was not funded sufficiently in the early years of the policy, it becomes very difficult to keep the policy in force later in life.
The second issue that people may face is that the actual performance of the sub accounts does not match what was illustrated. Sometimes a very high rate of return will be used to illustrate a policy, such as 8% to 10%. If the mutual fund sub-accounts within the policy do not perform as well as the illustrated rate of return showed, then the owner of the policy may not end up with enough cash in the policy to cover the increasing insurance costs. When the market is down, the insurance costs will rob an even higher percentage of the total cash in the policy, and limit future growth. Projects always assume straight line growth, but anyone who has invested money in the stock market that linear growth is the only thing you can count on never happening.
Another issue is that people take advantage of the flexible nature of universal life policies. As long as there is sufficient cash to pay insurance charge deductions, the policy stays in force. Many people will do a good job of building their cash initially, but realize that they can skip payments or stop payments for a period of time and the policy will not lapse. While this is true, and it is good for people in the short term, it is starving the policy of the cash value it needs to stay in force later when costs are high. People also take loans and withdrawals from these policies, further destroying cash value.
No matter the cause, a lower cash value means that out of pocket costs will be very high at some point. This puts the policy at a very high chance of lapsing for the average person. Most people do not understand how the policy is structured to work for their benefit when it is properly funded.
Variable Life Insurance Can Work For People With Money
Variable universal life insurance works well for a small subset of people. These are people who have sufficient money to fund the policy at least as well as the original illustration intended it to be funded. These policies work the very best when most of the total funding takes place within the first few years. The problems with a VUL policy (overwhelming charges due to low cash value) do not exist when large payments are made into the policy. Especially during periods of high market growth the policy will make money faster, and the long term charges to the owner will be lower with a VUL policy than with a traditional whole life insurance policy.
It works because a high cash value will appreciate with the market over time, building faster than the insurance charges are being taken from the cash. A higher cash value will also lessen the “net amount at risk” from which charges are based. Essentially with high enough funding the policy becomes an investment account which can be passed on tax free to the beneficiaries.
The biggest issue in the industry is that most sales are not to people with sufficient financial resources, but they are to people with moderate resources. Most people can not afford to truly fund their policy to the level that it needs to be funded. The vast majority of people looking at life insurance (99%) should focus their attention to Term Life or Whole Life insurance. Only people who are sophisticated enough to understand how the policy works, what the goals and advantages of using it over whole life insurance are, and people with large financial resources to fund it properly, should even consider purchasing a variable universal life insurance policy.
Stay away from Variable Universal Life insurance. Unless you are an extremely sophisticated investor with trust planning needs, odds are that a traditional life insurance policy will fit your needs better.